Boom or bust?

With area rents as sky-high as the buildings going up, is the multifamily boom headed for a fall?

By Jan Wilson

(page 2 of 3)

Bullish for now

We asked other experts around town for their opinions. Steve Harms, director of pre-construction at Tri-North Builders, believes any slowdown is at least a couple of years out. “The first thing everyone looks at are vacancy rates,” Harms states. Another factor is the city’s willingness to consider TIF for larger projects. “If they start backing off, it’s worth checking out,” he says. “There may be other factors, but market saturation is one of them.”

And what if signs hint at a slowdown? “We wouldn’t look at any new projects,” Harms explains. “Rents start stabilizing and once rents go down, it’s good for consumers but not developers. It would slow things up pretty quickly, even with
a 4.5% vacancy rate.”

Jeff Tubbs, vice president of business development at Findorff, agrees that any slowdown in multifamily development, if it occurs, is down the road a bit. “We have not seen any softening,” he states. “We continue to work with developers that are looking for additional sites and lots to do more housing. We get indicators through architects and lenders and both are remaining very busy and looking at deals for new apartment complexes, so the demand is still great out there.”

With a slowdown of absorption in the luxury apartment market, some believe Madison needs more middle-of-the-road multifamily construction. Photo by Chelsea Weis

Kian Wagner, director of investment sales and acquisitions at Oakbrook Corp., agrees that Madison has always been resilient and the market remains healthy. “What we’re starting to see is more interest from larger groups who are viewing the positive attributes and long-term resiliency.” Case in point, he says, was Artis REIT’s purchase of the Vanta portfolio. “That was a newsworthy event and planted a flag here locally that said ‘this is an institutional market or portfolio worthy
of national and international interest.’”

Why is that important? Wagner describes a typical investment life cycle: “You buy it, you run it, you hopefully increase the value, and you sell it. So if you’re an existing owner here and you want to refinance your property, if there are comparable sales out there at good numbers, that allows you to get better terms when you’re financing your property. More activity and turnover only benefits the market.”

Wagner says it’s difficult to gauge the success of any project unless you are privy to a behind-the-scenes look. “From an outward appearance, one project may seem like the best in town. But what you don’t know is what the anticipated rent levels are versus what the project actually got, so it’s hard sometimes to know how healthy a project is even though it may be fully leased.”

Brian Wolff, vice president at CBRE, projects a strong 2017 with supply projected to outpace demand slightly in 2018. “Madison has always been revered for its recession-proof economy,” Wolff notes. “It’s not just the millennials. While a majority of the newcomers are in their 20s and 30s, another big group is the aging, empty-nest baby boomers. What both groups share is their tendency to form smaller households.”

Wolff acknowledges the numbers of people expected to move to the area, but says the industry can’t just continue to assume everyone will be able to afford luxury apartments. “There needs to be more middle-of-the-road construction. Everyone seems to go after that luxury market, but that’s where the slowdown for absorption is occurring, in the upper end. That’s where we’re starting to see it.”

The benefit Madison has, he says, is that as young tenants age and move to the suburbs (either to rent or own), they’ll be replaced by a new wave of young renters. “The community won’t stop growing,” he states. “Lenders are very comfortable with multifamily vacancy rates in this city.”

Peter Mortenson, senior vice president at US Bank, is one such lender. Whether or not the multifamily building boom busts, he says, is still to be determined. “The most likely scenario is that we’ll continue to build because there’s interest from development in creating more multifamily projects from a capitalist/entrepreneurial aspect. Also, the capital market (banks, financial services) are willing to put debt on future projects.”

But larger banks, he notes, including US Bank, Wells Fargo, and Chase, are “taking a pause but not saying no to everything.”

Lenders, Mortenson explains, look at market rents in general, which vary widely around the area. Generally, he says, a high-end project downtown rents for about $2 per square foot per month, or $2,000 a month for a 1,000-square-foot apartment.

“So, if a developer comes in saying they’ll get $2 per square foot per month for rent, in my mind I say that might be today’s rent but tomorrow’s could be less. We might discount that to $1.80 or $1.75 given a building’s location, amenities, quality, or other factors.”

Loan-to-value ratio is an important consideration when deciding whether to lend, adds Mortenson, with developers typically wanting between 65% to 80% loan-to-value. An even more important determinant, though, is loan-to-cost. “Value is an arbitrary number,” he states. “Cost is fixed or based on fact. So when developing a project from the ground up, we look much harder at loan-to-cost to make sure the developer and their equity providers have skin in the game.”

Loan-to-cost is a key factor, he explains, particularly because of Dodd-Frank rules. On a $20 million project, lenders would like developers to have adequate capital — usually 15% to 20% at a minimum.

“Equity at risk is a big thing for examiners when they look at banks and commercial loan portfolios. They want to know that a bank is looking at a developer’s equity at risk because if there’s a problem, if there’s not a lot of equity at risk relative to the total amount of the deal, you won’t get a lot of help from your developers. But if they have significant equity at risk, say $2 million to $3 million on a $20 million project, they’ll pay more attention.”

That doesn’t mean the banks are pulling back, he says, but in general they’re being more prudent about supply and demand. “I’m a debt provider. I don’t get any upside. If rents increase tomorrow, all I get is my principal return and whatever interest I charge. So we have to be realistic, but if we keep bringing on more and more product, rents will certainly have downward pressure.”

Mortenson’s view, like others, is that eventually the supply and demand balance will favor supply. At that point he says, consumers will have more housing options “and the projects that are deficient from the design or layout or location or amenity standpoint will be the ones that first experience downward rent pressure.”

To compensate, Mortenson suggests a developer that is “smart with his lender” and provides room for rents to decline with relatively little pain will be okay. The more aggressive developer, on the other hand, will be less successful at fighting a downward rent cycle. “Someone sitting on a bunch of cash and looking to acquire assets for nickels on the dollar will be the winner.”

So will the multifamily housing bubble burst in the Madison area? If so, when?

Brad Hutter, president/CEO/owner at MIG Commercial Real Estate, watches industry blogs, particularly from Harvard University, and studies real estate cycle models for clues. Since the late 1870s, economists have been tracking the national real estate cycle’s ebbs and flows. In the 1930s, economist Homer Hoyt determined that the predictability of the nation’s real estate market, predicated by supply and demand, had been on an 18-year cycle since 1800. In 1997, economist Fred E. Foldvary revisited the concept, predicting:

“The next major bust, 18 years after the 1990 downturn, will be around 2008, if there is no major interruption such as a global war.”

Boom. People, including Hutter, took notice. “That was pretty impressive,” Hutter says. “The point is, they’re getting better and better at making these predictions.”

Many in the industry still subscribe to the 18-year model, which suggests a national housing bust could hit again around 2026. Plenty of signs would precede such an event, and other occurrences — wars, interest rates, and presidents — could alter it.